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12 May 2008
Impact on wider economy means UK not out of the woods just yet
The equity market will continue to be volatile, trading between hopes of financial system stability and further downgrades
When I last wrote in January, I thought the problems facing the financial markets would not be easily fixed and would slow the UK economy. Although I am not surprised by the severity of the problem, the impact on the wider economy has been unexpectedly rapid. The implications of the credit crunch for households and corporates are becoming apparent.
The Bank of England has been forced to take action, allowing banks to deposit illiquid prime mortgage loans in return for Government debt and cutting interest rates by 50bps. The RBS rights issue, thought to be the start of a number of fund raisings in the banking sector, suggests that much is being done to stabilise the financial system and cover further sub-prime losses.
A lot of this poor news is already factored into the bank share prices, but the wider impact on the UK economy will continue to resonate. With the housing market struggling and disposable incomes under pressure from rising energy, fuel and food price inflation, I remain very cautious regarding the consumer.
At the beginning of the year I felt the UK economy would not fall into recession as the Bank of England had scope to respond. However, with inflation outlook remaining a problem and potentially worsening, the scope for the Monetary Policy Committee to reduce rates at the required speed is hindered.
The outlook for corporate profits continues to deteriorate and earnings estimates are falling rapidly. At turning points, PE multiples do not give a very strong signal on valuation. Even the ostensibly attractive dividend yield valuation measure is becoming more suspect after RBS cut its dividend per share as a consequence of its rights issue. However, I do get some feeling of value looking at the yield on the market excluding the financials, where balance sheets on the whole are stronger.
The equity market will continue to be volatile, trading between hopes of financial system stability and further downgrades to corporate earnings. Resources stocks and those exposed to faster growing overseas economies should perform well and also benefit from weaker sterling. We shall continue with our strategy to focus on companies that should deliver good growth in this slowing economic environment.
The market has already discounted a gloomy scenario with an indiscriminate de-rating across all sectors, some more justifiably than others. Therefore, if the UK can avoid a recession, the stock market should rise. There is also potential support from further interest rate cuts later this year and an increased appetite for M&A.
Bull points
- Much is being done to stabilise the financial system
- The market has already discounted a gloomy scenario
Bear points
- Implications of the credit crunch are becoming apparent
- Disposable incomes under pressure from rising inflation
Hugh Duff
Senior Investment Manager, UK Equities
The Scottish Investment Trust PLC
Published in Investment
Week
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